Econ 101

Principles of Economics
I.

Economic Concepts for the First Midterm Exam

Economics
1. Definition (a social science which studies how scarce resources can be used in the most efficient
way in order to achieve maximum satisfaction of human wants (needs).
2. The Economic Prospective
Scarcity and Choice
1. Resources are scarce and can only be used for one purpose at a time
2. Scarcity requires that choices have to be made
3. The cost of any good is the value of what must be given up to obtain it
Rational Behavior
1. Individuals make decisions to maximize their utility (satisfaction)
2. Firms make decisions to maximize their profits
Marginalism (Marginal Revolution, 1871)
1. Marginal means incremental (additional)
2. Individuals engage in economic activity as long as MBMC
3. Firms engage in economic activity as long as MRMC
3. Theoretical Economics
Reality is complex
Models and Theories are developed
Dependent variable as a function of independent variables
Ceteris Paribus
4. Policy Economics
Fiscal Policy (changes in the level of government spending or taxes in order to
manipulate the level of output in the economy or the price level)
Monetary Policy (Any action taken by the Federal Reserve bank in order to manipulate
the real output (GDP) or the price level)
Trade Policy (manipulating tariffs and quotas)
5. Economic Goals (Full employment, Price Stability, Economic Growth)
6. Microeconomics vs. Macroeconomics
Microeconomics (decisions of individual decision-making units such as firms or
consumers)
Macroeconomics studies economy as a whole
1. Output of the Economy (GNP, GDP)
2. Employment (Unemployment)
3. Price Level
7. Use of Graphs
Types of relationships between variables
1. Direct (Positive)
2. Inverse (Negative)
3. No relationship
Types of relationships between variables
1. Linear
2. Nonlinear
Slope of a line
1. Slope of a curve at a specific point is equal to the slope of a straight line
tangent to the curve at that point
2. A Line is tangent at a point if it touches the curve only once at that point
3. Slope of a straight line [Slope=(Vert Change)/(Horiz change)]
Slope = y/x = (y2 y1)/(x2 x1)
4. Types of slopes
Positive

5.

II.

Economic Resources
1. Definition and Classification of resources
Definition of a resource (anything that is necessary for the production of goods and
services)
Property Resources (Land, Capital, Raw Materials)
Human Resources (Labor, Human Capital, Entrepreneurship)
2.

The Economic Problem (three basic questions for every society)

What to produce?
How to produce?
For whom to produce?

3.

Economic Systems
Capitalist System (private ownership of resources)
Socialist System (public ownership of resources)
Efficiency
Allocative efficiency
Productive efficiency

4.

III.

Negative
Horizontal (zero)
Vertical (Infinite)
Equation of a linear relationship (y = a + bx)
y- dependent variable
x-independent variable
a-vertical intercept
b-slope

5.

Production Possibilities Curve (Frontier)

Definition (PPF shows the maximum amount of alternative combinations of goods and
services that a society can produce at a given time when there is full utilization of
economic resources and technology)
Graphical representation
Efficient and inefficient points and PPC
Unattainable points and PPC
Shifts and pivoting in PPC (Accumulation and reduction of physical and human capital
and technological changes)

6.

Opportunity Cost
Definition (the value of what had to be sacrificed in order to obtain one additional
unit of the original good)
Calculation of the opportunity cost
The law of increasing opportunity costs

7.

Circular Flow Model

Individual Markets
1. Demand
Definition (A schedule showing the amount of a good that consumers are willing to
purchase at different prices during a specific time period, holding all other variables
constant)
Demand Curve (A curve illustrating demand)

2.

3.

IV.

Law of Demand (Other things equal, an increase in a products price will reduce the
quantity of it demanded)
I. Income Effect (The increase in the quantity purchased of a commodity with a given
money income when the commodity price falls)
II. Substitution Effect (The increase in the quantity purchased of a commodity (as a result
of switching from the purchase of other commodities) when its price falls
Determinants of Demand (Income, price of related goods, # of consumers, tastes and
preferences, expectations [income, price])
Shifts in the Demand Curve
Supply
Definition (A schedule showing the amounts of a good that producers are willing to
supply at different prices during a specific time period, holding all other variables
constant)
Supply Curve (A curve illustrating supply)
Law of Supply (Other things equal, an increase in a products price will increase the
quantity of it supplied)
Determinants of Supply (Change in availability of resources, Change in resource
prices, change in technology, taxes and subsidies imposed on the producers, prices of
other goods that require the same technology to produce them, expectations, # of
suppliers)
Shifts in the Supply Curve
Market equilibrium
Definition (occurs at the point of intersection of demand and supply)
Graphical Representation
Equilibrium price and quantity (equilibrium price is the price that clears the market, it
is the price where QD=QS=Q*)
Mathematical Approach to equilibrium
Effect of the shifts of the supply and demand curves on the equilibrium quantity and
equilibrium price level
Simultaneous changes in Demand and Supply
I. D, S Q, P?
II. D, S P, Q?
III. D, S P, Q?
IV. D, S Q, P?
Price Distortions
1. Price ceiling (a government instituted maximum price for a commodity in the
market)
2. Price floor (a government instituted minimum price for a commodity
Shortage and surplus
Shortage (occurs when commodity price is below the equilibrium price and
QD>QS)
Surplus (occurs when commodity price is above the equilibrium price and
QD<QS)

International Trade
1. International Linkages
Goods and services flow
Capital and Labor Flows
Information and technology flows
Financial flows
2. Open and Closed Economy

3.
4.

5.

Open economy (connected with the rest of the world through trade and financial
relationships)
Closed (has no trade or financial relationship with, and completely isolated from, the
rest of the world.
Exports and Imports
Trade Balance
Positive trade balance ([X-M]>0)
Negative Trade Balance ([X-M]<0)
Zero Trade Balance ([X-M]=0)
US Trade
Top 5 US International Trading Partners
1. Canada
2. China
3. Mexico
4. Japan
5. Germany
Top 5 Countries Receiving U.S. Exports
1. Canada
2. Mexico
3. China
4. Japan
5. United Kingdom
Top 5 Countries Supplying U.S. Imports
1. China
2. Canada
3. Mexico
4. Japan
5. Germany

6.

Comparative Advantage and Trade

The law of comparative advantage (In a two-nation, two commodity world, each nation
should specialize in the production of the commodity with the lower opportunity cost).
Gains from specialization and trade
Consumption Frontier (The various alternative combinations of the commodities that a
nation can consume)
7. Reasons to trade
Comparative Advantage
Increasing Returns to scale
8. Obstacles to Trade
Import quotas
Import Tariffs
9. Arguments for Trade restrictions
Protection of domestic labor force from cheap foreign labor
Reduction of domestic unemployment
Protection of infant industries
Protection of industries vital for national defense
10. Multilateral Trade Agreements and Free-Trade Zones
1. GATT (General Agreement on Tariffs and Trade)
2. World Trade Organization (WTO)
3. The European Union
4. North American Free Trade Agreement (NAFTA)

V.

11. The foreign exchange market

Demand for a foreign currency
1. The role of imports
2. The role of capital exports (capital invested abroad by domestic
investors)
Supply of a foreign currency
1. The role of exports
2. The role capital imports (capital invested domestically by foreign
investors)
Exchange rate determination
Appreciation and depreciation of the foreign and domestic currency
Output of the Economy (GDP and GNP)
1.

Definition of GDP and GNP

GDP is the market value of all final goods and services produced in the domestic
economy during a given year
GNP is the market value of all final goods and services produced in an economy during
a given year by the factors of production owned by residents of that country

2.
3.

What is included in GDP? (only final goods and services)

What is not included in GDP?
Intermediate goods
Economic Bads (Katrina)
Non-production transactions
o Used goods
o Financial transactions (Purchases of stocks and bonds)
o Government transfer payments
Non-market transactions
o home improvements done individual homeowners
o cooking meals at home
o illegal transactions (drugs, prostitution, illegal immigrants working for cash)
Types of GDP
Nominal GDP (The market value of all final goods and services produced in the domestic
economy during a one-year period measured at current prices)
Real GDP (The market value of all final goods and services produced in the domestic
economy during a one-year period measured at constant prices)
Potential GDP
The maximum output a domestic economy can produce without putting an
upward pressure on the price level
The real output an economy can produce when it fully utilizes all available
resources and technology
GDP Gap (GDP Gap = Potential GDP Real GDP)
Converting Nominal GDP into the Real GDP
GDP per capita (per capita GDP = GDP/Population)
Calculation of GDP (two approaches)
a. expenditure approach (Y=GDP=C+I+G+X-M)
b. Individual components
Consumption-total household expenditure of households on goods and services
Investment (items including all final purchases of machinery, equipment and tools by
business firms, all construction, changes in inventories)
Government Expenditure (All types of government spending)
Exports (goods produced domestically and sold abroad)

4.

5.

 Imports (goods produced in foreign countries and sold in the domestic economy)
income approach (income derived from the production and sales of all goods and services
in the economy)
GDP=National Income + Indirect Business Taxes + Depreciation + Net Foreign Factor
Income
National Income Accounts [see Campbell R.McConnell and Stanley L. Brue, Economics:
Principles, Problems and Policies, Seventeenth Edition. New York: Irwin McGraw-Hill, 2006.
a. GNP
b. Net Investment [Net Investment = I Depreciation]
c. NDP (Net Domestic Product)
NDP=GDP-Depreciation
d. National Income (NI)
NI = Wages + Rental Income +Interest Income + Proprietors Income + Corporate
Income
e. Personal Income (Includes all income received whether earned or unearned)
PI=NI - Social Security Contributions - Corporate Income Taxes Undistributed
Corporate Profits + Transfer Payments)
f. DI (Disposable Income)
DI = PI - Taxes
c.

6.

VI.

Conventional Price Indexes

a. CPI (a price index that measures the change in prices of a fixed basket of more that three
hundred goods purchased by a typical urban consumer).
b. PPI (A price index for goods at the wholesale level, specifically finished goods, intermediary
goods, and crude materials)
c. GDP Deflator (The price index for the output included in GDP)
d. Calculation of a simple price index

VII.

Inflation
a. Definition (A rise in the general level of prices)
b. Causes (Demand-pull, Cost-push, Growth in Money Supply)
c. Calculation: t = [(PIt PIt-1) / PIt-1]
d. Deflation (fall in the economys price level)
e. Disinflation (A reduction in the rate of inflation)

VIII.

Economic Growth
1. Definition (An increase of GDP or GDP per capita over some time period)
2. Causes of Economic Growth
Capital Accumulation
Increase in Labor Productivity (generally through education and training)
Improvements in Technology
Other factors (Institutions, Geography, Trade, Policy, etc.)
1. Geography Hypothesis (Jeffrey Sachs and others)
Distance from the equator is highly related to income per capita.
Countries that are far from the equator are relatively rich, and
countries that are close to the equator are relatively poor.
Most of the differences in income per capita can be explained by
geography, climate and ecological differences across countries
2. Institutional Hypothesis (Daron Acemoglu and others)
Differences in institutions are the main determinant of differences
in income per capita across countries.
To the extent that geography matters, it has influenced institutions
in the past.
Important institutional features

3.

4.
5.
6.
7.

Expropriation risk
Property rights enforcement
Rule of law
Many others
Problems with institutional analysis
Not clear how to reliably quantify institutions
Not clear which institutions (from the entire range
possible) are the most important for economic growth
Graphical Representation of economic growth
PPF approach
Production Function approach
GDP growth rate
GDP/Capita Growth Rate
Difference between GDP Growth Rate and GDP/Capita Growth Rate
Population Growth Rate

IX.

Business Cycles
a. Definition (alternating rises and declines in the level of economic activity)
b. Phases of a business cycle (Recession and Expansion)
c. Causes of business cycles
Fluctuations in Total Spending
Fluctuations in Investment Spending (the most volatile component of aggregate
Expenditure)
Monetary and Fiscal Policy
Technological Shocks

X.

Unemployment
a. Types of unemployment (frictional, structural, cyclical)
b. Labor Force
Definition (consists of people who are willing and able to work)
Calculation of a Labor Force
c. Calculation of the unemployment rate
Unemployment Rate = {[# of Unemployed] / [Labor Force]}
LF = POP - Institutionalized under 16 not in LF
Not in LF (Retirees, full-time students, homemakers)
d. Major criticisms of the BLS approach
i. Part-time workers
ii. Discouraged workers
e. Full level of employment/Natural rate of unemployment
Real GDP=Potential GDP
There is no cyclical unemployment
f. Cost of unemployment (Okuns Law)